Brace for the fiscal cliff – it may be Washington's best shot at compromise

By Michael J. Hicks

Tuesday, November 20, 2012 - 12:01 am

The spirit of compromise survived less than 24 post-election hours. By then House Republicans ruled out any tax increase, while the president called for a tax increase on the rich. I think this is increasing evidence that we will come very close to the fiscal cliff. This is because the fiscal cliff might well be the best compromise that can be worked out in D.C. in the coming months. Let me explain.

Generally, one side of our body politic wishes to shrink the size and scope of government. The other wants to expand the reach and powers of government. Neither side has done a sufficient job in persuading a sizable majority that they are right (although, to be fair, one side has huge short-term advantages by handing out Scooby snacks). A compromise on dealing with our budget deficit requires one or both sides to concede central parts of their arguments. This has potentially huge consequences for the political economy of future elections, so there's not much compromise in the wind.

The spending cuts of the fiscal cliff will be far less broadly injurious than most suppose. That is simply because there is a lot of fat to cut before it becomes painful. The one exception will be a collapse of defense acquisitions, which will pummel many communities. Taxes are the big issue.

Republicans have vowed not to raise taxes. They argue with factual accuracy that the Bush taxes made the income tax system more progressive and that many high-income earners are actually small companies that do not pay corporate taxes. They also contend, with less empirical support, that higher taxes on these groups will stall the economy. Higher tax collections and (worse still) higher rates will slow the economy, but won't kill it.

Democrats wish to eliminate the Bush tax cuts, but only on the rich. They have had great fortune in demonizing the Bush tax cuts, but in reality Democrats are terrified of a complete repeal, as well they should be. The end of the Bush tax cuts will increase by a third the number of households who pay income taxes. This group consists of households earning roughly $30,000 to $50,000 who comprise more than one in five voters and voted overwhelmingly for President Obama in the last election (57-42 percent).

Moreover, the fiscal cliff also restores the pre-stimulus Social Security payroll taxes of two percent of earnings. Altogether this means a household earning $40,000 would see a tax hike of nearly $2,000 beginning January 1, 2013. High earning households will pay much more (just like its opponents claimed), but as a share of income, the repeal will clobber middle-income households.

I would personally like to see wholesale tax and entitlement reform. That means more revenue, but through a cap on loopholes and deductions, a lifetime limit on most entitlements along with later retirement age for young workers. I am not betting on it though; I suspect we'll drive off the fiscal cliff, just like Thelma and Louise.

Michael J. Hicks is director of the Center for Business and Economic Research and associate professor of economics at Ball State University.